Indirect Cost

An indirect cost is a cost that benefits several products, services, projects or departments at once, and so cannot be traced to any one of them in a practical, economical way. Rent on a factory, the salary of a production supervisor, electricity for a shared building, IT support and the cost of the finance team are typical examples. To find the full cost of a product or project, indirect costs must be divided up, or allocated, among the things that use them.

Indirect costs are the counterpart of direct costs, which can be traced straight to a particular item, such as the wood used to build a table or the hours a lawyer bills to one client. Whether a cost is direct or indirect depends on the cost object being measured. A plant manager's salary is indirect when costing a single product but direct when costing the plant as a whole.

Indirect costs fall broadly into two groups:

• Manufacturing indirect costs, usually called factory or manufacturing overhead, include indirect materials such as glue and cleaning supplies, indirect labor such as supervisors and maintenance staff, and factory depreciation, utilities, insurance and property taxes. Under absorption costing, these are included in inventory cost.
• Non-manufacturing indirect costs include administrative expenses such as head-office salaries, accounting, legal and human resources, and shared selling costs such as corporate advertising. These are normally treated as period expenses on the income statement.

Many indirect costs are fixed costs, but not all; electricity for a shared production line, for example, rises with activity. Shared costs that serve several departments are also known as common costs.

Allocation usually follows three steps: collect indirect costs in cost pools, choose an allocation base that reflects what drives each cost, and calculate a rate. A common formula is:

Here $\text{Total indirect cost in the pool}$ is the cost being shared and $\text{Total units of the allocation base}$ is the total of a measure such as labor hours, machine hours, floor space or number of transactions. Each cost object is then charged the rate multiplied by its use of the base.

For example, an engineering consultancy has $900,000 of indirect costs for the year, including office rent, administrative staff and software licences, and its consultants work 30,000 billable hours. Its indirect cost rate is $30 per billable hour. A project that uses 1,200 hours of consultant time at a direct labor cost of $60 per hour therefore costs $72,000 in direct labor plus $36,000 in indirect costs, a total of $108,000. If the client is billed $130,000, the project makes $22,000 after covering its share of overhead. Activity-based costing refines this approach by using several pools, each with its own driver, which tends to give more accurate results where products differ greatly in how they use resources.

Indirect cost recovery is a major issue for government contractors, universities and nonprofits. In the United States, federal contractors follow the Federal Acquisition Regulation and Cost Accounting Standards, and grant recipients follow the Uniform Guidance at 2 CFR 200. These rules specify which indirect costs are allowable and how they are allocated. Many organizations negotiate an indirect cost rate with a federal agency; those without one may use a de minimis rate, which the 2024 revision of the Uniform Guidance raised from 10 percent to 15 percent of modified total direct costs.

Poorly chosen allocation bases can distort product costs, making some products look more profitable than they are and others less so, which can lead to bad pricing and product decisions. Managers should also remember that allocated indirect costs are often not avoidable in the short term: dropping a product does not remove its share of factory rent. For decisions, it is usually better to look at which costs actually change. Accounting systems should keep indirect costs visible in cost center reports so that managers responsible for a cost center can control them, a practice central to cost accounting.